Sui Generis letter for the second quarter ended June 30, 2017.
Friends and Investors,
As the expression goes, misery loves company; so why is it then that whenever the consensus moves in our direction we begin to squirm in discomfort? First things first, we should clarify that we aren’t suggesting that we are a miserable group of people, we just think critically so interpret that how you will. Perhaps more importantly, we would like to talk about why exactly we are much more comfortable making contrarian calls, and how it should allow us to continue outperforming the TSX. We are never contrarian for the sake of it because that of course would be absurd, but there is a certain obvious logic in exploiting the laziness of the market’s collective group think. Once everyone agrees, it’s far too late…you’re in the 9th inning, maybe even extras. It is the exploitation of this exuberance that allows us to feel very confident in our short book and if you’ve been a reader of our commentaries for any length of time, you know our short book is what we truly believe sets us apart. That said, every portfolio needs compelling long positions.
We’ve tried finding value in energy and so far that has only led to losses of both money and sleep. However, we find it intuitively difficult to sell oil producers while crude trades below the marginal cost of production. To make money staying short oil (which after 2015 is something we can speak to) would require investors to make some very dangerous assumptions amidst an incredibly crowded short oil trade. The first is to assume that the willful ignorance of “fully-cycle” economics (ie. the all-in cost to find, develop & produce a barrel of oil) will continue unabated and that turning a profit will never matter again. Don’t believe producers in Texas when they tell you they can make money down to $40 per barrel, they can’t. The second and perhaps most dangerous assumption is that providers of capital will line up to continue taking enormous losses.
Economics always matter and at some point the evaporation of billions of dollars of capital over the last two years will eventually matter. It is now obvious to us that the latter is starting to happen. Energy funds are shutting down around the world, the TSX energy index is trading 52% below its 2014 high and barely above the 2016 lows when oil was below $30 per barrel. Now the spread between high yield energy bonds and general corporate high yield bonds has exploded higher since the new year, moving from a reasonably tight 30 basis points to nearly 2%. The cost of funding an oil company is rising rapidly and after learning the hard way via several disastrous financings in Canada, it’s safe to assume equity markets are shut off to producers and now the bond market is saying no more because…just one more time, the economics don’t work at $45 per barrel. We will reiterate that we are not long term oil bulls, but from these levels it’s hard not to believe in decent upside.
Being Greedy When Others Are Greedy - Getting Short
“Be greedy when others are fearful and be fearful when others are greedy” is a catchy and convenient way to remind yourself that Warren Buffet suggests that the best way to make money is to be a contrarian. And we agree that after doing the proper diligence, buying a stock at peak fear will typically yield overly positive returns over the following months. The issue with practicing this form of discipline of course is that as we type this in July of 2017, investors aren’t particularly afraid of anything so reasonably valued long opportunities aren’t exactly plentiful; we’re in the middle of the Teflon market. We recently managed to step in at the right time on some of Canada’s battered lenders; a profitable endeavor thus far but hardly repeatable given the unique opportunity presented by the fever pitch of fear around Home Capital (which we do not own). So what’s a fund that prides themselves on (of course not exclusively) short positions and contrarian calls to do in 2017? Expand the short book.
We always seem to be achieving better returns for our investors when we’re in our natural state, shorting unjustifiably expensive equities. Four of our top positive contributors for 2017 have been short positions in market darlings: Transforce, Exchange Income Corp., Badger Daylighting & Teck Resources. In each instance, the chorus of analysts telling us we didn’t understand the story was deafening, and in each instance we began covering our position once the short pitches started making their way around the street. Being contrarian goes both ways and the avoidance of crowded trades is probably most important when covering short positions. Once a stock becomes a consensus short it’s already too late, the money has been made. Borrowing costs start to rise and finding the incremental seller of the stock becomes that much more difficult.
In an effort to avoid what we think is an irrationally bullish market we have been running our fund with only the slightest net short positioning for the last six months and have still managed a positive return year-to-date. We now feel it’s high time to start leaning short again, particularly in Canada. We believe that monetary tightening, the strong Canadian dollar and trade headwinds will all conspire to weaken Canadian equities. As you might expect we believe the energy sector should outperform, but only on a relative basis. We believe the back half of 2017 is built for Sui Generis and we look forward to profitably navigating it with our investors.
The Sui Generis Team